Many investors lost interest in bonds over the past few years as interest rates plunged and the stock market offered a seemingly guaranteed way to make 20%+ per year. This year's market volatility has reminded people that tremendous stock market returns are not guaranteed. If you are suffering from market-related nervousness, an allocation into bonds can help stabilize your portfolio returns.

Over the past 75 years (actually longer -- we just have reliable data back to 1926), stocks have been the best-performing asset class available, outperforming bonds, Treasury bills, and inflation. Based on this and other data, The Motley Fool has advocated placing your long-term investments (those you will hold for at least five or more years) in the stock market. This advice should maximize your absolute returns, assuming history provides an indication of future opportunities.

While investing entirely in stocks generally maximizes long-term returns, it also tends to maximize intra-period volatility. It isn't unusual to see the prices of individual stocks and indices to move up or down 20% to 50% within a one-year period. With almost all of the movement being positive over the past few years, many people have ignored the fact that stocks can also go -- and stay -- down.

Market Volatility
This year's market performance seems to be reminding people of this reality. While the year started off fairly strong, year-to-date returns among the major indices haven't been that attractive. As of last Friday, the Nasdaq Composite Index was down 11% for the year, the Dow Jones Industrial Average had fallen 7%, and the Standard & Poor's 500 Index had drifted 2% lower. Even the mighty Nasdaq 100, led by the technology stocks of the new economy, was down 5%. The returns on many individual stocks, particularly those caught up in the Internet and biotech euphoria earlier in the year, are off 50% to 90% or more.

It's way too early to know whether this move is the start of a bear market that will last for some time, or an opportunity to get into stocks before they jump dramatically. It truth, the only way we'll definitively know is looking at the future in retrospect. That's the way we learned that the 1929 crash and the "Nifty 50" collapse in 1973 were the start of lengthy bear markets. It's also how we found out that the 1987 mini-crash and 1998 panic were tremendous buying opportunities. Until the future occurs, we don't know exactly what will happen to the financial markets.

The recent stock market volatility has shaken quite a few people. It's unnerving to open a 401(k) statement and see that your portfolio has fallen from $25,000 to $20,000 in the span of one month. Some people think that if they can't handle this volatility, they need to stop buying stocks. That's the farthest thing from the truth.

Considering Bonds
There are lots of people who don't have the risk tolerance to see their portfolio values fluctuate with the stock market. Even if they don't need the money for a long period of time, they can't tolerate significant variance in their underlying portfolio value. Instead of shunning stocks entirely, these people could benefit from adding a balance of bonds to their portfolios.

Bonds and other fixed-income securities have become quite unpopular over the past few years as equities hogged the limelight. As bond yields fell and stock returns increased, fewer people considered bonds valuable investment opportunities. While including bonds in a portfolio will often reduce absolute returns over long periods of time, they also tend to reduce return variability -- particularly if you invest in short- and intermediate-term (or inflation-adjusted) bonds.

Return Variance Reduction With Bonds One of the best examples of how bonds reduce the variance in portfolio returns is in the real-money retiree portfolios maintained here at Fool.com. For those of you not familiar with this section of the site, retiree David Braze (TMF Pixy) keeps track of three portfolios composed of his own money. Portfolio updates and a column about retirement investing are published weekly.

Pixy's three retirement portfolios are named "Racy," "Reasonable," and "Reluctant." The core equity strategy of each is the same: invest in the Foolish Four stocks. The only difference among the three portfolios is that Racy is 100% invested in stocks; Reasonable is 75% invested in stocks, 25% invested in bonds; and Reluctant is 50% invested in stocks, 50% invested in bonds.

Pixy expects that the Foolish Four will provide higher returns than bonds and the S&P 500 over long periods of time. By having a portion of his Reasonable and Reluctant portfolio in bonds, however, he can reduce intra-period volatility.

Since the retiree portfolios were started on December 10, 1999, the Foolish Four has entered a dismal spell and is down 18%. This decline has hammered the value of the Racy portfolio by a similar amount as it is invested entirely in Foolish Four stocks. If you look at the other two retiree portfolios, however, you'll see how bonds mitigated volatility. The Reasonable portfolio is down 13% since inception, whereas the Reluctant portfolio is down only 7%. By throwing bonds into these two portfolios, Pixy was able to reduce the loss during a severe retreat in his stocks.

Variance Reduction Works Both WaysInvestors contemplating putting bonds in their portfolio to reduce volatility need to remember an important factor: Volatility will be lowered in both positive and negative markets. If Pixy's stocks had returned a positive 18% instead of a negative 18%, the bonds in the Reasonable and Reluctant portfolios would have dragged down their performance. Racy portfolio's 100% equity stance would have led it to the highest overall return, followed by the other two portfolios in the order of equity allocation.

You're probably best off staying entirely invested in stocks if you can stomach the inherent market volatility and plan to keep your money in place over the long haul. If you're finding that big drops in stock prices make you want to abandon the stock market, however, you may want to think about adding a dose of short- or intermediate-term bonds to your portfolio. These additions should reduce your overall portfolio volatility, while still letting you partially enjoy the higher expected returns of equities.